After touching $75 per barrel in early October, West Texas Intermediate crude has plummeted below our forecast of $55 per barrel. The 30% drop in oil prices from the 2018 peak coincided with a period of weakness for broader equity markets, making energy stocks look much more attractive than they did when OPEC met in June.
Given our bearish long-term oil outlook, we think investors are more likely to find value in the volume-driven areas of the sector, namely midstream and refining. Nonetheless, the recent sell-off has created buying opportunities for multiple integrated firms, exploration and production companies, and service firms too.
OPEC Meeting Does Not Impact Forecasts
The December OPEC meeting did nothing to change our long-term outlook for global oil prices. We still forecast a 2022 crude price of $55 per barrel for WTI and $60 per barrel for Brent. This sits roughly 15% below current 2022 WTI consensus but 8% above current prices.
We think oil prices are trading near midcycle levels, creating much more opportunity in oil-related stocks, as we detail beginning on Page 16 than six months ago at the last OPEC meeting. Indeed, the WTI price is down 28% since June.
However, we disagree with those that see the recent oil price weakness as a temporary plunge with a significant long-term rebound certain to come. Oil prices may fluctuate wildly in the short term because of geopolitical issues, OPEC cuts, and supply disruptions and could rebound quickly.
But we think those who buy oil-related stocks today thinking that long-term prices will be materially higher will be disappointed.
U.S. Shales Sets Global Prices
U.S. shale is the marginal source of production in our global framework. We contend that other potential marginal sources, including Canadian oil sands and offshore projects, will need to match U.S. shale costs or risk being competed out of existence.
We expect that upcoming offshore projects will, on average, best U.S. shale, while oil sands production will sit above shale, though it's important to note that costs are not homogeneous for each type of supply, as seen by the height of each.
Energy Sector Valuations Look More Attractive
The drop-in oil prices, and the largely contemporaneous drop in broader equity markets, has created more opportunity in the energy sector. Six months ago, at the last OPEC meeting, with oil prices at $70 per barrel versus our midcycle estimate of $55 per barrel, we thought energy valuations looked stretched. Today, we see more value with oil below $55 per barrel.
The midstream and refining industries look the cheapest, in our view, and don't carry much commodity price exposure, a positive, given that we are still bearish versus consensus on long-term oil prices.
Top picks include Enbridge, Enterprise Products Partners, and Marathon. We also see several compelling values in integrated firms. Our favourites include Total and Royal Dutch Shell (RDSB). Names we like with more exposure to commodity prices include Diamondback Energy, Cenovus, and Schlumberger.
Refining and Marketing: Valuations Look Attractive
The shares of independent refiners soared in the wake of Hurricane Harvey last year as falling product inventories and widening crude spreads improved margins. Tax reform further increased earnings expectations while the collapse in RIN prices has added momentum to merchant refiners Valero and HollyFrontier. With IMO 2020 on the horizon, the market continued to bid up shares for much of this year.
Sentiment has turned, however. Initially concerns about delays to IMO 2020 weighed on the shares, while more recently, weakening gasoline margins and narrowing crude spreads have become a concern. We are not entirely surprised, as we previously noted valuations were reflecting elevated earnings expectations for the next few years.
The sharp sell-off of the past few months, however, has left many names trading in 4-star territory, our refining and marketing coverage currently trades at median price/fair value ratio of 0.77, most notably Marathon Petroleum and Valero. We think both firms are well positioned to capitalise on a volatile margin environment, given their quality assets and geographic dispersion.
Both should also benefit from IMO 2020, which we think will proceed as originally planned, meaning several years of strong margins based on the potential three million barrels of oil per day swing in demand from fuel oil to distillate that is likely to boost diesel margins and widen light-heavy spreads.
We expect both to continue their generous shareholder-return policies with growing dividends and large repurchase programmes.
